Monday, January 4, 2010

Thoughts of the Day - 2010

We begin a new decade. Purists will claim that the new decade begins in 2011, but this works for my purposes. It was ten years ago that we realized that the millennium change would not shut down computers around the world and that the Federal Reserve’s precautionary measures of pumping money into the system proved unnecessary, though that stance came to symbolize a decade of low interest rates and easy money that came to an horrific end in the summer of 2007.

Besides intelligence, characteristics of success in America have long been based on diversity, meritocracy, hard work, innovation, and the willingness to take risk with an overlay of optimism. While none of these qualities are uniquely American, we have historically blended them better than most, in large part because we are truly a nation of immigrants. At times such as these, with the economy in trouble and confidence low, there is a risk that we push aside those characteristics in favor of less attractive ones – cynicism, based upon the failure of people and institutions; dependency, based upon a government, which can convert compassion into subservience; a xenophobic fear causing people to turn inward toward nationalism and the substitution of meritocracy with seniority (a favorite of unions.)

A manifestation of the last ten years in equity markets was high volatility with a downward bias – an attractive combination for the proliferation of hedge funds that multiplied over the decade like rabbits in a vegetable patch. Hedge funds have been around since at least 1949 when Alfred Winslow Jones founded A. W. Jones & Co. Michael Steinhardt started Steinhardt, Fine & Berkowitz in 1967 and six years later George Soros began the Soros Fund. Others followed suit. While never equaling mutual funds in asset size, they dominated trading with a combination of leverage and trading skills.

The market, over the past decade, proved accommodating. The decade began with the market commencing a thirty-three month decline. The S&P 500 closed December 31, 1999 at 1469.25. By October 9, 2002 it had declined 692.49 points to 776.76. It then proceeded to rally 785.71 points, over five years, to an all-time high of 1562.47 on October 10, 2007. An eighteen month decline took the index to 672.88 on March 9, 2009. We closed on December 31, 2009 at 1115.10 – a price decline of 24.1% over the ten year period, but one that encompassed 1227.93 points on the upside and 1582.08 points on the down side – a level of volatility made to order for newly started hedge funds.

It is easy to peer out from our snow encrusted homes and offices and despair of the risks that abound – a time of unprecedented government intrusion; a Congress divided by partisanship; Local, State and Federal deficits that dwarf anything we have known in the recent past; a world in which terrorism persists and one in which a terrifying dictator is likely months away from nuclear capability, and an economy with fifteen million unemployed with asset prices – homes and equities – far below their highs of a few years ago.

But we are absent the one factor that always concerns me – complacency (except, perhaps, for certain commodities.) We watch, listen and read daily of these problems; so we know, one, they are, at least in part, being discounted and two, they are being addressed.

To the extent that history is a guide (and one should always be wary of history as a guide, for times are never the same), it seems that the decline in volatility, both in terms of the VIX and in terms of daily moves, is likely to persist. Expectations remain low. Investors continue cautious. The buy-and-hold, long term investor has been declared, if not dead, an endangered species. However, the essence of our character has not changed, and I, for one, would not rule out a ten year period during which confidence is gradually restored, with optimism ultimately tossing cynicism over board.

The rip tides that permitted hedge funds to prosper may well abate. Such an environment, should it occur, could well be more suitable to long-only investors. We shall see.

On a more personal level, the next decade will see enormous changes in my grandchildren. For all but the youngest, it will be their coming-of-age decade – a time when they exchange the innocence for the enticement of young adulthood. Heartbreak and tears are part of growing up, but so are joy and discovery. I only hope the transformation is achieved with as little pain as possible.